Mezzanine Fund

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Last Updated:September 22, 2023

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What Is A Mezzanine Fund?

A mezzanine fund is a group of investors who put their money into mezzanine funding for acquisitions, growth, recapitalization, or management/leveraged buyouts. A company's capital structure is a hybrid of equity and debt.

The most common form of this financing is preferred shares or subordinated and unsecured debt. On the balance sheet, it is classified as equity. This type of funding is used when an existing organization needs to expand.

It is a type of financing that combines equity and debt. It is a type of financial arrangement in which the lender has the option to convert the debt into equity under certain specified and agreed-upon terms and conditions.

This Fund invests in mezzanine debt opportunities such as organic growth, acquisitions, recapitalizations, or management buyouts. On the other hand, a private equity fund will provide funds to an organization in the form of equity.

The main goal of raising this type of Fund is to reduce the risk of capital assets and equity being lost. This type of Fund is typically provided by a venture capitalist and the organization's senior debt lender.

Borrowers receive funding quickly with little or no due diligence in this type of fundraising, and the lender delivers the Fund with insignificant collateral securities.

Key Takeaways

Mezzanine funds combine equity and debt for acquisitions, growth, or buyouts. They bridge the gap between senior debt and equity, offering flexible options for businesses.
Mezzanine funding uses preferred shares or subordinated debt, often convertible to equity. It helps businesses expand and raise capital without giving up complete control.
Mezzanine funds provide capital to companies, with potential equity conversion. They're used to minimize risk for both venture capitalists and senior debt lenders.
Mezzanine financing offers flexibility, tax benefits, and growth capital. It suits expansion, acquisitions, and refinancing, benefiting both small and established businesses.
Businesses risk losing control, and covenants may impose restrictions. Mezzanine debt is costlier than traditional financing and requires thorough preparation.

Understanding Mezzanine Fund

It is the capital layer that sits between secured senior debt and equity. This type of capital is typically not protected by assets and is lent solely to the ability of a company to repay the debt through free cash flow.

These funds are primarily used to fund growth opportunities such as mergers and acquisitions, new sales processes or products, production facility expansion, or other growth activities.

The equity-to-debt ratio is first calculated in this funding by assessing the expected revenue from growth and the costs incurred. Then, if the agreed-upon loan amount is not repaid within the specified period or terms, these loans are frequently converted to equity.

Unless the company declares bankruptcy, the Fund is reasonably protected in its investments. During the liquidation process, such fund holders take precedence over equity shareholders.

These funds generate a return on investment in one of three ways: cash interest, equity ownership, or interest payable in kind.

These funds are appropriate only in certain circumstances, such as when the private equity sponsor is only willing to invest 70% of the total required. In this case, the owner will be required to invest 30%.

However, their burden is reduced if the owner brings a mezzanine investor who can contribute 10% to 15%.

Why is Mezzanine Finance Needed?

This funding entails risk and is thus typically pursued by large investors. However, here are some of the reasons that one should be aware of:

These are viable options for small business owners who need funds to expand because they are easy to obtain. The business owner is not obliged to offer any asset as collateral.
The structure of Mezzanine debt is quite flexible because borrowers can borrow from multiple sources, and thus the amount from each becomes smaller.
The interest on mezzanine debt becomes tax deductible. This is why small business owners seek such debt. They must pay interest, but only after the tax deduction.
These funds can be the best debt solution for companies that are not eligible for sufficient bank debt but require flexible terms.
An excellent option for companies in need of growth capital. Those companies which are not growing quickly enough or are dissatisfied with the terms must consider Mezzanine funding.
This funding does not require a personal guarantee or collateral.
It is a collective capital that wishes to invest in mezzanine finance for buyouts, growth, restructurings, management stock repurchases, or leveraged buyouts.
This financing raises the value of existing shareholders' stock, although they will have a smaller ownership stake. It also gives business owners the money they require to acquire another company or expand in a new market area.

Structure of mezzanine fund

These fundings can be completed using various structures, depending on the transaction's specific objectives and the company's existing capital structure. Subordinated notes and preferred stock are the two most common forms of this funding.

Mezzanine lenders, usually specialist mezzanine investment funds, seek a certain rate of return from securities comprised of any of the following or a combination of the following:

Cash interest is the cash-based periodic payment on a percentage of the outstanding balance of the mezzanine funding. The interest rate can be fixed for the entire term of the loan, or it can fluctuate in tandem with LIBOR or other base rates.
Payable in kind interest (PIK interest) is a periodic means of payment in which the interest payment is made by raising the principal balance by the amount of the interest.
Ownership: In addition to the usual interest payments associated with debt, mezzanine capital will frequently include an equity stake in the form of attached warrants or a convertible bond-like feature.

In almost all cases, the ownership component in mezzanine securities is accompanied by either cash interest or PIK interest, and in many cases, both.

Characteristics of mezzanine funds

The following are the characteristics of a mezzanine fund:

1) This financing is for businesses that have progressed beyond a start-up stage: It is not for new businesses. Instead, it is intended for those who have not yet filed for an IPO but require additional growth capital to expand.

2) It is a simple and flexible way of financing and is also known as subordinated debt. It is especially beneficial for small business owners who are not yet ready to pay a high cost of capital for equity financing.

These are ideal for small business owners because they are tailored to their specific needs. Another reason it's so adaptable is that it's an unsecured loan, which means the borrower doesn't have to provide collateral to secure the loan.

3) These are extremely risky investments. The unsecured nature of the funding makes it riskier; the yield is higher to cover the interest rate and repayment risks.

If small business owners cannot generate sufficient revenue, they will be unable to repay the debt on time since the interest rate on mezzanine financing is quite high.

As a result, it is always advised that this debt not exceed twice the company's cash flow.

4) These funds provide investors with regular interest payments.

Uses of mezzanine fund

Some of the prominent uses of this Fund are:

1. Leveraged Buyouts

It is used in combination with other securities to fund the corporation's purchase price in leveraged buyouts.

Mezzanine capital is typically used to bridge the funding gap between less costly financing and equity.

Before turning to this Fund, a financial sponsor will often exhaust all other sources of capital. For example, in a leveraged buyout, financial sponsors seek to use mezzanine capital to reduce the private equity firm's invested capital.

Mezzanine lending institutions have a lower target capital cost than the private equity investor; using mezzanine capital can effectively boost the private equity firm's investment returns.

2. Finance for real estate

Developers frequently use mezzanine loans in real estate finance to secure supplemental financing for development projects. A second-ranking real estate mortgage frequently secures these mezzanine loans.

Depending on the relationship between the first mortgage lenders and the mezzanine debt lender, governed by an Intercreditor Deed, standard mortgage foreclosure proceedings can take more than a year.

When should one consider using the mezzanine Fund?

A person should consider the following things before going for this Fund:

A) For Purchasing

Companies typically seek these funds when acquiring another company. If a firm understands that acquiring another company will increase its revenue stream, it will want to do so.

However, the firm would not always have liquid cash, so that it would require quick funds.

B) Shareholder Takeovers

Typically, established companies are interested in retaining majority ownership. Such investors may sometimes wish to repurchase the company's shares to increase their stake in the company. For such purposes, it is extremely useful.

C) Refinancing

Organizations may also use this Fund to increase the flexibility of their debt capital structure. These ready funds ensure companies have sufficient funds to pursue opportunities such as shareholder buyouts and acquisitions.

D) Expansion

Aside from the three activities listed above, businesses can use them to expand into new territory. Rapid growth is necessary for businesses to increase their revenue stream. These funds can assist them in accomplishing the same in a short period.

Advantages and Disadvantages of mezzanine fund

The advantages of a Mezzanine Fund are:

The owner seldom loses complete control of the company or its direction. As long as the company grows and prospers, its owners are unlikely to face any interference from the mezzanine lender.
Lenders interested in this financing are typically long-term investors who provide stable capital.
These lenders can be of great strategic value.
This financing increases the value of existing shareholders' stock, whereas mezzanine equity reduces the value of the stock.
This funding provides business owners the funds they require to acquire another company or expand into a new product or market area.

The disadvantages of a Mezzanine Fund are:

This financing may result in a loss of control over the business, especially if projections do not pan out as planned or if the equity portion of the borrowing is large enough to give the mezzanine creditor a larger share.
Restriction covenants may be included in subordinated debt agreements. The lenders frequently require restrictive covenants. Requirements include that the borrower not borrow more money, refinance senior debt from traditional loans, or create additional security interests in the company's assets.
Business owners who accept mezzanine financing may be forced to accept restrictions on how they spend their money in certain areas, such as important personnel compensation.
Mezzanine debt is more costly than conventional or senior debt financing.
Preparing for mezzanine financing can be a difficult and time-consuming process. Most of these transactions will take at least three months, and many will take twice as long.

Example of mezzanine fund

Following are some of the examples for a better understanding of the topic:

A) Example #1

Let us assume a restaurant chain company is looking to buy another restaurant. Please assume that the target restaurant has annual profits of $250,000, and the owners of the restaurant are looking to sell it at a valuation of $1 million.

The buying company is simultaneously in talks with a senior lender to invest up to 65%. Assume the senior lender has agreed to invest $650,000 at an annual rate of 8%. Now the buying company is required to pay only $350,000.

Here, the return on investment of the senior lender is $52,000 due to the 8% annual interest rate. The senior lender's remaining operating profit is $198,000 after deducting the interest paid. After applying a 35% tax rate, the profit after tax comes out to be $136,700.

B) Example #2

Assume Mr. Samuel owns an ice cream shop. He wishes to grow his company. However, he does not want to use traditional equity financing. Rather, he opts for mezzanine financing.

He approaches mezzanine financiers and requests mezzanine loans. The lenders state that warrants or options are required for mezzanine loans. Mr. Samuel must agree to the terms set by the mezzanine lenders because the loans are unsecured.

So Mr. Samuel accepts $150,000 by demonstrating an $85,000 annual cash flow. He accepts the loans but fails to repay them because his ice cream shop does not generate enough cash flow. The lenders take a portion of his ice cream parlor and sell it to get their money.